Mostly original content that examines financial surreality in equity markets in general, and the Japanese Stock Market in particular.

Thursday, November 10, 2011

Monkey on Your Back

This is my last word on Olympus. There are more gripping things going on elsewhere. First, the Facta investigative reporters who originally uncovered and drew attention to the suspicious accounts at Olympus should be commended. They should be commended for their perseverance. Without their work, it is possible that the abuse could have escaped notice for who knows how long. They did not however, as far I understand, connect the dots nor understand why.

There is an analogy here. Madoff clients (Fairfield Sentry I believe) were ascribed the return on their statements apparently via OTC split-strike conversion positions. These were long stock with hedged option combinations that however exercised guaranteed a rate of return - like a futures calendar spread implied a rate of return equivalent to the promised return. Of course at the time, few (certainly not me) knew, nor even imagined that the positions and the statements themselves were pure fabrication. We (myself and colleagues) believed that he was doing something else (front-running, impact-trades, something more risky that he wish not to reveal, etc.)which, to satisfy reporting requirements, he booked accordingly. It was sufficiently plausible for the trusting, the auditors (who were bent), and the ignorant, even though there wasn't ever sufficient underlying activity to relate to the OTCs on the statement. The reason, in the end, we now know.

The transactions highlighted by Facta indeed were similar in intent to Madoff's fake bookings which was to hide something with something plausible. And they were similar in that once in the spotlight, both fell to pieces since both were rather implausible. That is, in my opinion, where the similarities end. Madoff was in its entirety, a fraud, excepting a modest broker-dealer. Olympus, from what I understand from conversations with someone purportedly close to the original repair-bond transactions which the sham advisory fees were seemingly meant to dispose of, had large financial investment losses - large enough when the company had YEN 150 billion market cap, that disclosure would materially impact their balance sheet hence financing, not to mention the embarrassment. The zaitech activities, often made possible by essentially "free financing" from the issuance of bonds with attached warrants, leaving them with cheap funds to invest, but little expertise to properly take advantage of it, resulting in loss-making investment assets, but fixed-obligations to be repaid eventually. Oooops.

But Olympus today, has a balance sheet 10-times (or some similar multiple) the size of that from 1990. A billion dollar loss in 1990 was HUGE. In 2010, its BIG, but relatively manageable. Altis, Gyrus, Turbochef or whatever these were called, are to a certain extent irrelevant in that they were coincidental. They were transactions costs - some small fraction - in relation to what they were attempting to dispose of. This is not condoning it. This is trying to plausibly explain it. IF they lost 50% of the true value of these operating gnats, it would be rounding error in the Olympus equation. The advisory fees, after all were NOT siphoned, but used settle the outstanding investment losses, presumably with their "Michael-Clayton-like fixers" or repair-bond arrangers.

The fears of investors presently are valid: Is that EVERYTHING? If they did it to repair the balance sheet, might they not have done it to the income statement too? Like Leeson's suicidal cover-up, could one mistake have led to much larger losses in covering it up?? Are there lawsuits and penalties that might arise creating large future liabilities for present Olympus shareholders? Are their financing arrangements threatened? Could they be delisted? Bond covenants and so forth.... All worth asking.

That said, zaitech is dead and buried. When the drugs wore off, it was embarrassing, with the most incompetent long since transferred to the corporate travel office in the cellar. It is highly likely the losses and repair transactions were all the investment losses. And to be fair to Olympus, it wasn't like it was Michael Vick and Dog Fighting: everyone was doing it at the time (ask anyone foreign who structured similar transactions in Tokyo). Olympus was different, I think, ONLY in that by 2003, they still hadn't come clean (like Yakult Honsha and others) or disposed of them. It is likely that they hadn't accumulated MORE for reasons just stated, but sti had the so-called Monkey on their Back.

Could they have been diddling the income statement? Yes, of course, but...practically it is a different story and more difficult to continue to diddle an income statement. There are just too many people with information. Knowledge of a repair bond on the balance sheet can be limited to a few people - and the foreigners involved were bound to strict confidentiality, before the atmosphere regarding such transactions visibly soured. And for a company with numerous subsidiaries with different year-ends, can be hidden from even well-intentioned auditors for years. And it is likely they didn't need to. But I cannot say for certainty (and there are perhaps few people that can). BUT, I might turn this around and ask "IF they were systematically diddling the income statement, why would you appoint a gaijin as your CEO?" I do not think they would.

I can discuss the other risks, with even less certainty. Could they be delisted? Yes, but the precedent is that it is unlikely. Could they be sued? There is a cultural aversion to litigiousness, but possibly I suppose. And could bank financing be in jeopardy? This seems highly unlikely. Japanese banks are not so mercenary with corporate kin, and Olympus IS a big customer, and the web of responsibility spreads far and wide, so I cannot see a Japanese bank lender murdering a still-solvent client, however tainted they may be, for everyone has some dirty laundry in their cupboard.

And so, when I look at it, and ask the questions, I arrive back where I started YEN 300 ago: while not pretty, this endeavor, and the subsequent farcical cover-up was legacy business. If you've reason to believe otherwise, or that it goes deeper and is more pervasive (i.e. the income statement) then please let me know if for no other reason than to be kind to someone who is by nature, loss-averse (over the longer-term).

Escape From the Rat Race

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